TOPIC 21

The markets for inputs

FACTORS OF PRODUCTION

• Factors of production are inputs used to

produce goods and services.
– Labour
– Capital
– Land
– Raw materials
– Intermediate goods
– Energy,……

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 INPUT MARKETS
• In many ways factor markets resemble
goods markets.

• However, they differ in one important way

– the demand for a factor of production is a derived
demand from a firm’s decision to supply a good in
another market.
– So, for example, the demand for computer
programmers depends on how much of computer
software is supplied in the goods market.

INPUT MARKETS
• Input or factor markets, like other markets in
the economy, are governed by forces of
supply & demand.
– For example: We can describe wage
determination for a worker by supply & demand
for labour in a labour market.
– Same for any input (capital, land etc).

• The supply/demand model is adaptable.

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 INPUT MARKETS
(a) The market for apples (b) The market for apple pickers

Price of Wage of
apples apple
pickers
Supply Supply

P W

Demand Demand

0 Q Quantity of 0 L Quantity of
apples apple pickers

INPUT MARKETS
• Some inputs (e.g. labour, capital, land,
energy) are important in the economy.

• Thus we make a specific study of the factors

determining their supply & demand.

• Lets start with labour.

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 THE LABOUR MARKET
• Most labour services are not final services ready
to be enjoyed by consumers.
– Usually they are inputs into production of other
goods.
• A firm hires workers to produce goods and services. The firm
then sells the goods and services and pays the workers.

• Recall that the production function illustrates the

relation between quantity of inputs & quantity of
output.

PRODUCTION FUNCTION
Quantity
of apples
Production
300 function
280

240

180

100

0 1 2 3 4 5 Quantity of
apple pickers

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THE MARGINAL PRODUCT OF LABOUR
• Again recall that the marginal product of labour
is the increase in the amount of output from an
additional unit of labour.

MPL = ∆Q/∆L = (Q2 – Q1)/(L2 – L1)

– e.g., if the firm hires one extra unit of labour (say the
4th unit of labour) then the MPL is 40 apples
– Similarly if 5 extra units of labour produce 300 extra
units of output the estimated MPL is 300/5 = 60
apples (on average).

THE MARGINAL PRODUCT OF LABOUR

• Diminishing marginal product
– refers to the property that the marginal product of an
input declines as the quantity of the input increases.
– In other words, as number of workers increases, MPL
declines.
• Because when more workers are combined with less
quantities of the fixed levels of other inputs (capital, land,
etc), the workers become less and less productive.

• You can see that the production function

becomes flatter as numbers of workers rises.

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THE MARGINAL PRODUCT OF LABOUR
• Diminishing marginal product
Marginal
product

Marginal product

0 Quantity of
apple pickers

THE LABOUR MARKET

• We make the following assumptions when

analysing the labour market:
– The market for goods and services is competitive.
• Firm is a price taker in the good’s market
– The labour market has many buyers (firms) and
sellers (workers), and is competitive.
• Firm is also a wage taker in the labour market.

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 VALUE OF THE MARGINAL
PRODUCT
• The value of the marginal product is the
marginal product of an input times the price of
the output.
– the extra revenue the firm gets from hiring an
additional unit of a factor of production.

VMPL = MPL X P

– e.g. If the marginal worker produces 40 extra units of

output that sell for $4/unit then the VMPL is $160.

LABOUR DEMAND BY A
COMPETITIVE FIRM
*(Output price= $10, Wage =$500)
Value of
Output Marginal marginal
Labour (# (boxes product of product Wage/ Marginal
workers) per week) labour labour week profit
(VMPL = (∆ Profit =
(L) (Q) (MPL = ∆Q/∆L) P * MPL) (W) VMPL − W)
0 0 - - - -

1 100 100 $1000 500 500

2 180 80 800 500 300
3 240 60 600 500 100
4 280 40 400 500 –100
5 300 20 200 500 -300

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 LABOUR DEMAND BY A
COMPETITIVE FIRM
• Here the firm should employ exactly 3 workers
to maximise profits.

• Earlier we have discussed how competitive

firms make profit-maximisation decisions in
terms of output
P = MC

• We can do the same in terms of inputs.

LABOUR DEMAND BY A
COMPETITIVE FIRM
• To maximize profit, a competitive, profit-
maximizing firm hires workers up to the point
where the value of the marginal product of
labour equals the wage.
VMPL = wage.

• The VMPL is diminishing so firm should stop

employing when the value of the last worker’s
production just equals the cost of that worker.

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 LABOUR DEMAND BY A
COMPETITIVE FIRM

LABOUR DEMAND BY A
COMPETITIVE FIRM
• At low levels of employment, the value of the
marginal product exceeds the wage, so hiring
another worker would increase profit.

• At high levels of employment, the value of the

marginal product is less than the wage, so the
marginal worker is unprofitable.

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 LABOUR DEMAND BY A
COMPETITIVE FIRM
• The value of marginal product curve is the
labour demand curve for a competitive, profit-
maximising firm.
– Given a wage a firm will employ workers until their
VMPL equals the wage.
• A decrease in wage is an incentive for the firm to hire more
workers
• An increase in wage, on the other hand, is an incentive to
hire less workers

WHAT CAUSES THE LABOUR

DEMAND CURVE TO SHIFT?
• The output price
– Since VMPL = MPL X P
An increase in the price raises the value of the
marginal product of each worker, and shifts the
labour demand curve.

• The supply of other factors

– An increase in the quantity available of one factor of
production (e.g., capital) affects the marginal
product of labour and shifts the labour demand
curve.

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 WHAT CAUSES THE LABOUR
DEMAND CURVE TO SHIFT?
• Technological change
– Usually technological advances raise the marginal
product of labour, which in turn shifts the labour
demand curve to the right.
– However, technological change can sometimes be
labour saving, e.g., robots, mechanised farming etc.
• In this case labour demand will be reduced and shift the
curve in an opposite direction (leftwards).

LABOUR SUPPLY
• The labour supply curve shows how workers’
decisions about work & leisure respond to
wages.

• There is a trade-off between work and leisure

because of limited available time
– The opportunity cost of leisure is foregone wage
– An upward-sloping labour supply curve means that
increased wages induces workers to work more &
take less leisure.

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 LABOUR SUPPLY
• The effects of an increase in wage
– Substitution effect: Higher wage means that the
opportunity cost of leisure is greater
• Labour spends less time for leisure (because its more
expensive now to do so) and work more

– Income effect: Higher wage means that labour

earns more for its efforts
• Labour spends more time for leisure since it can earn the
same as before by working less

LABOUR SUPPLY
• When substitution effect is stronger than the
income effect
– we have an upward-sloping labour supply curve

• When income effect is stronger than the

substitution effect
– We have the possibility of a backward-bending
labour supply curve

• We ignore the possibility of a backward-

bending labour supply

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 LABOUR SUPPLY
Wage
(price of
labour)
Supply

0 Quantity of
labour

WHAT CAUSES THE LABOUR

SUPPLY CURVE TO SHIFT?
• Changes in tastes/preferences over time
– Preference for smaller family size enables women to
work more.
– On the other hand, increased preference for leisure
reduces labour supply

• Changes in alternative opportunities

– Enhanced unemployment benefits.
– Higher wages in another industry may cause a
switch in occupations

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 WHAT CAUSES THE LABOUR
SUPPLY CURVE TO SHIFT?
• Changed demographics
– Migration
• when immigrants come to a country, the supply of labour in
that country increases and the supply of labour in the
immigrants’ home countries contracts.
– Changed population growth rate (birth or death
rate).

LABOUR MARKET EQUILIBRIUM

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 LABOUR MARKET EQUILIBRIUM
• Key ideas
– The wage adjusts to balance the supply and
demand for labour.

– The wage equals the value of the marginal product

of labour.
• Each firm in the competitive labour market takes the
equilibrium wage rate as given and hires workers until the
value of the marginal product equals the wage.

– Any event that shifts the supply of labour or demand

for labour will change the equilibrium wage.

SHIFTS IN LABOUR SUPPLY

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 SHIFTS IN LABOUR SUPPLY
• Suppose that immigration increases the
number of workers in the labour market. The
supply of labour shifts to the right from S1 to S2.
– This puts downward pressure on the wage
– the fall in the wage makes it profitable for firms to
hire more workers
– resulting in reduced marginal productivity of workers
– lowering the value of the marginal product so that it
equals the lower equilibrium wage

SHIFTS IN LABOUR DEMAND

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 SHIFTS IN LABOUR DEMAND
• Suppose that the price of a good rises.
– The price increase raises the value of the marginal
product of labour.
– Hiring more workers is now profitable.
– The labour demand curve shifts rightwards from D1
to D2.
– This puts upward pressure on the wage
– and the wage rate increases to match the higher
value of marginal product.

OTHER FACTORS OF PRODUCTION

– CAPITAL & LAND
• Capital is the equipment and structures used to
produce goods and services.
– The economy’s capital represents the accumulation
(stock) of goods produced in the past that are being
used in the present to produce new goods and
services.

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OTHER FACTORS OF PRODUCTION
– CAPITAL & LAND
• Important: Always measure inputs in terms of
services yielded per period
– in flow terms rather than stocks of machines or
areas of land.
– Example:
• Services yielded by land or capital per year.

OTHER FACTORS OF PRODUCTION

– CAPITAL & LAND
• For each of these factors we need to
distinguish between the purchase price and the
rental price.
– The purchase price is what a person pays to own a
factor of production indefinitely.
– The rental price is what a person pays to use a
factor of production for a limited period.

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 OTHER FACTORS OF PRODUCTION
– CAPITAL & LAND
• Because wage is effectively the rental price of
labour, much of what we have learned about
wage determination applies also to the rental
prices of land and capital.

– The rental prices of land & capital are determined by

supply & demand in the factor markets.
– The firm hires these inputs until the value of the
inputs’ marginal product equals the inputs’ price.

OTHER FACTORS OF PRODUCTION

– CAPITAL & LAND
Market for land Market for capital

Rental Rental
price of price of
land Supply capital Supply

P P

Demand
Demand

0 Q Quantity of 0 Q Quantity of
land capital

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 DIGRESSION ON LAND

• Previous figure shows land supply as rather

inelastic.
– There are limited opportunities to expand the supply
of land – ignoring improvements in land quality.
– Land’s rental price is determined solely by its
demand
– And a tax on land rents will not affect supply.
• There are no DWLs – no distortions or inefficiencies.

DIGRESSION ON LAND

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 LINKAGES AMONG THE FACTORS
OF PRODUCTION
• Factors of production are used together in the
production process
– the productivity of one factor is dependent on the
quantities of the other factors available to be used in
the production process.

• When the supply of any factor changes, it

affects the productivity and hence earnings of
other factors.

LINKAGES AMONG THE FACTORS

OF PRODUCTION
• If inputs are complements
– increased availability of one boosts marginal product
of other input & its rental price.

• Labour & capital are often complements.

– Suppose a natural disaster destroys huge amounts of
capital
– On one hand, rental price of capital increases
– On the other hand, less capital is available per worker
• MPL and consequently labour demand reduces
• Wages decline

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 LINKAGES AMONG THE FACTORS
OF PRODUCTION
• Thus, the change in supply of capital may also
have an effect on the labour market.

• Black Death (14th Century Europe).

– resulting in the deaths of an estimated 100 million
people in Eurasia
– Wages doubled and land rents halved

LINKAGES AMONG THE FACTORS

OF PRODUCTION
• If inputs are substitutes
– increased availability of one reduces the demand of
the other input & its rental price.

• Male & female workers are often substitutes.

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 LINKAGES AMONG THE FACTORS
OF PRODUCTION
• Since factors of production are used together
– Hence difficult to choose inputs one at a time.

• The firm would like all inputs to be employed

such that for each
VMP = input cost.

• But pursuing this one input at a time will

change marginal product of other inputs.
– Ultimately need to choose all inputs simultaneously.

SUMMARY
• Three important production inputs are labour,
land & capital.

• Demand for an input is a derived demand

coming from firms using the input to produce
goods and services.

• Competitive, profit-maximising firms hire each

input to the point where VMP equals input
price.

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 SUMMARY
• The supply of labour arises from individuals’
trade-off between work & leisure.

• An upward-sloping labour supply means

people respond to increased wages by
enjoying less leisure & working more.

• Prices paid to inputs adjust to balance supply &

demand.

• Inputs are compensated according to their

marginal product.

SUMMARY
• Because inputs are used together, marginal
product of any one depends on the quantities
of all.

• Hence a change in supply of one input alters

the earnings of all.

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